Inaction spells almost certain economic doom

The current almost universal abdication of responsibility to help struggling countries is filling economists with a sense of dread

By Paul Krugman / NY Times News Service

Among economists who know their history, the mere mention of certain years evokes shivers. For example, three years ago Christina Romer, then the head of US President Barack Obama’s Council of Economic Advisers, warned politicians not to re-enact 1937 — the year then-US president Franklin D. Roosevelt shifted, far too soon, from fiscal stimulus to austerity, plunging the recovering economy back into recession. Unfortunately, this advice was ignored.

However, now I am hearing more and more about an even more fateful year. Suddenly normally calm economists are talking about 1931, the year everything fell apart.

It started with a banking crisis in a small European country (Austria). Austria tried to step in with a bank rescue — but the spiraling cost of the rescue put the government’s own solvency in doubt. In themselves, Austria’s troubles should not have been big enough to have large effects on the world economy, but in practice they created a panic that spread around the world. Sound familiar?

However, the really crucial lesson of 1931 was about the dangers of policy abdication. Stronger European governments could have helped Austria manage its problems. Central banks, notably the Bank of France and the US Federal Reserve, could have done much more to limit the damage. Nobody with the power to contain the crisis stepped up to the plate; everyone who could and should have acted declared that it was someone else’s responsibility.

And it is happening again, both in Europe and in the US.

Consider first how European leaders have been handling the banking crisis in Spain. (Forget about Greece, which is pretty much a lost cause; Spain is where the fate of Europe will be decided.) Like Austria in 1931, Spain has troubled banks that desperately need more capital, but the Spanish government now, like Austria’s government then, faces questions about its own solvency.

So what should European leaders — who have an overwhelming interest in containing the Spanish crisis — do? It seems obvious that European creditor nations need, one way or another, to assume some of the financial risks facing Spanish banks. No, Germany will not like it — but with the very survival of the euro at stake, a bit of financial risk should be a small consideration.

However, Europe’s “solution” was to lend money to the Spanish government and tell that government to bail out its own banks. It took financial markets no time at all to figure out that this solved nothing, that it just put Spain’s government more deeply in debt. And the European crisis is now deeper than ever.

Yet let us not ridicule the Europeans, since many US policymakers are acting just as irresponsibly. I am not just talking about congressional Republicans, who often seem as if they are deliberately trying to sabotage the economy.

Let us talk instead about the Federal Reserve. The Fed has a so-called dual mandate: It is supposed to seek both price stability and full employment. Last week the Fed released its latest set of economic projections, showing that it expects to fail on both parts of its mandate, with inflation below target and unemployment far above target for years to come.

This is a terrible prospect, and the Fed knows it. US Federal Reserve Chairman Ben Bernanke has warned in particular about the damage being done to the US by the unprecedented level of long-term unemployment.